Why Hasn't Japan's Quantitative Easing Devalued the Yen More?

The value of a currency is determined by the interplay of supply and demand. When a central bank engages in quantitative easing (QE), it increases the money supply, which theoretically should lead to a decrease in the currency's value. However, Japan's yen has not devalued more despite its central bank's extensive QE programs. This article delves into the reasons behind this phenomenon, focusing on factors such as interest rates and the inherent demand for holding currency.

Understanding Currency Value through Supply and Demand

The principle of supply and demand applies to currencies in much the same way it applies to goods and services. An increase in the supply of a currency, typically due to central bank policies such as QE, should ideally lead to a decrease in its value. However, this is often not the case. The key is to understand the demand side of the equation, which is influenced by various factors, including the roles of the currency as a unit of account, a medium of exchange, and a store of value.

Key Drivers of Currency Demand: Unit of Account, Medium of Exchange, and Store of Value

1. Unit of Account: Currencies are used to measure the value of goods and services (e.g., pricing products). 2. Medium of Exchange: Currencies serve as a means to facilitate transactions (e.g., paying for goods and services). 3. Store of Value: Currencies can be held over time, retaining or gaining value.

These functions make holding a currency inherently valuable, independent of its current or predicted future value. Thus, the supply of the yen, while increased due to QE, has not necessarily resulted in a significant devaluation because of the strong demand for it as a unit of account, a medium of exchange, and a store of value.

Impact of Interest Rates on Currency Value

A country's interest rates play a crucial role in determining the value of its currency. Higher interest rates typically attract foreign investors, as they offer better returns on investments. Conversely, lower interest rates can lead to capital outflows and a potential devaluation of the currency.

Japan's Lower Interest Rates and Recent Trends

Japan has had consistently low interest rates for several years, with some periods of negative interest rates. This has reduced the attractiveness of holding Yen as a unit of return. However, despite these low rates, the yen has not devalued more significantly against major currencies like the euro.

As of early April 2023, the exchange rate US$1 to Yen was at 109.2. Today, it stands at 106.4, indicating a decrease but not a pronounced devaluation. During this period, there has been a notable strengthening of the yen against the euro, moving from 6.24 to 6.52 in April 2023.

Comparison with US Interest Rates

Japanese Interest Rates: Negative and flat for the past five years, making it less attractive as a store of value for return-seeking investors. As a consequence, the Yen is held mainly for non-return-related reasons, such as transactional purposes or investment in domestic assets.

US Federal Reserve Interest Rates: Recently, US interest rates have been sharply cut, making investments in the US more attractive relative to Japan. This shift has contributed to the relatively better perception of Japanese rates, leading to a slight stabilization or even slight strengthening of the yen against the euro.

While quantitative easing does increase the money supply, other factors such as low interest rates and the demand for currency as a reliable store of value can mitigate the effects of increased supply. This phenomenon can be observed through the recent exchange rate movements of the yen against both the euro and the US dollar, illustrating the complex interplay between supply, demand, and interest rates.

In conclusion, the reasons why the yen has not devalued more significantly despite extensive quantitative easing policies are multifaceted, involving both supply-side and demand-side factors. The strong support for the yen as a medium of exchange and a reliable store of value, coupled with the impact of recent US interest rate changes, plays a significant role in maintaining its relative value.